Distinguishing lost profits from reasonable royalties.

• Author: Lemley, Mark A.

INTRODUCTION

Patent damages are designed to compensate patentees for their losses, not punish accused infringers or require them to disgorge their profits. (1) The governing statute provides for "damages adequate to compensate for the infringement, but in no event less than a reasonable royalty." (2) Courts interpreting this provision have divided patent damages into two groups--lost profits, available to patent owners who would have made sales in the absence of infringement, and reasonable royalties, a fallback remedy for everyone else. (3) Traditionally, patentees want to prove lost profits because only that measure captures the monopoly value of excluding competitors from the market. As the statutory language suggests, reasonable royalties exist as a floor or backstop for those who cannot prove that they have lost profits as a result of infringement. (4) The rationale is that an infringed patent is valuable and could be licensed for a fee even by patent owners who don't employ the patent in the marketplace.

In practice, however, the lines between lost profits and reasonable royalties are blurring. In significant part, this is because courts have insisted on strict standards of proof for entitlement to lost profits. Specifically, patentees must prove demand for the patented product, the absence of noninfringing substitutes, the ability to meet additional demand in the absence of infringement, and the proportion of those sales that represent profits. (5) This in turn means that many patent owners who have in fact probably lost sales to infringement cannot prove lost profits damages and must fall back on the reasonable royalty measure. (6) The result is that courts have distorted the reasonable royalty measure in various ways, adding "kickers" to increase damages, artificially raising the reasonable royalty rate, or importing inapposite concepts like the "entire market value rule" in an effort to compensate patent owners whose real remedy probably should have been in the lost profits category. (7) Unfortunately, Congress is now considering locking one of those distortions--the entire market value rule--into reasonable royalty law. (8)

In Part I, I explain the strict requirements for proving lost profits and give examples of patentees who have failed to meet these requirements. In Part II, I explain how relegating these patentees to reasonable royalties has led to problematic changes in reasonable royalty law. Finally, I suggest in Part III that courts should draw a sharp division between the injury suffered by patentees who compete with infringers and those who do not. Patentees who compete should be entitled to the best estimate of lost profits, even if not all elements of proof are available. Those entitled to a reasonable royalty should get just that--a reasonable award that reflects what a buyer would have been willing to pay to license a valid patent. By distinguishing the two types of harm and the corresponding remedies, courts can end the overcompensation of patent owners in reasonable royalty cases.

1. LOSING ENTITLEMENT TO LOST PROFITS

   The traditional conception of patent protection is to give patent owners a means of excluding competitors from selling the patented product, thereby increasing their profits and therefore the incentive of putative patent owners to invent. This traditional conception requires exclusivity; the value of a patent is accordingly commensurate with the value of the market or market niche it controls. It explains why the normal remedy for infringement of a patent is an injunction against continued infringement. (9)

   Lost profits fit logically within this traditional conception. Giving patentees the profits they would have made absent the infringement effectively puts them in the same position as if they had had an injunction in place all along. (10) To the extent that it doesn't--when a patentee lost market traction early in a growing market and never built market share, for example--the law of lost profits has expanded over time to try to compensate the patent owner for those uses. (11)

   Proving lost profits has not been easy, however. Federal Circuit law requires that the prevailing patentee prove (1) the extent of demand for the patented product, (2) the absence of noninfringing substitutes for that product, (3) the patentee's ability to meet the additional demand by expanding manufacturing capacity, and (4) the extent of profits the patentee would have made. (12) Further, the cases require sophisticated economic analysis of the interrelationship between price and demand. For instance, claims of price erosion must be discounted to the extent that the higher prices a patentee could have charged absent competition would have driven away some consumers. (13) The cases also require inquiry into how the patentee would divide sales with other companies in the market that were either licensed or selling noninfringing goods. (14)

   Courts take these requirements seriously and quite often reject claims for lost profits. To begin, it should be obvious that patentees cannot possibly meet these requirements unless they participate in the market in direct competition with the infringer. (15) However, even competitors often have trouble demonstrating entitlement to lost profits. Sometimes this is because they actually didn't lose any profits, because, for example, purchasers didn't value the patented technology at all and would happily have switched to noninfringing substitutes. (16) Other times it is because the patentee itself couldn't have manufactured the products and therefore lost the sales. (17) Still other cases involve more technical failures of proof, for example a failure to adequately segregate profits from costs or a lack of economic sophistication in analyzing market demand and its elasticity. (18)

   A dramatic example is the foundational ease on patent damages, Panduit v. Stahlin. (19) In the opinion authored by Judge Markey, later Chief Judge of the Federal Circuit, the court held that the patentee had proven demand for the patented product, an absence of noninfringing substitutes, and the ability to exploit demand and therefore make sales. (20) Nonetheless, the court held that the patentee was not entitled to lost profits because it did not adequately separate profits from costs. (21) There was no dispute that Panduit accounted for variable costs or that it tried to exclude fixed costs as well. (22) But expert witnesses disagreed about the correct way to account for fixed costs, and the court concluded that because it couldn't be sure what fixed costs to include, it had to reject the lost profits claim altogether in favor of a reasonable royalty. (23)

   Once a patentee proves entitlement to lost profits, the scope of the resulting award can be quite expansive. Patentees can recoup losses on sales they in fact made if they can prove that they were forced to lower their prices to meet infringing competition. (24) They can capture the defendant's sales of unpatented goods that compete with the patented invention. (25) They are entitled to capture the value of sales of an entire product based on a single patented component if they can prove that the patented feature is what caused the sale, so that the defendant's infringement garnered a sale that otherwise would have gone to the patentee. (26) This is known as the "entire market value rule." (27) Patentees are entitled to capture profits based on the sale of "convoyed goods"--goods that are not part of the patented product at all, but that are sold in connection with the patented good and therefore likely would have been sold by the patentee if the patentee rather than the infringer had made the sale of the infringing good. Patentees are even entitled to capture sales by the defendant after the patent has expired, if those sales were made possible by infringing preparatory activity by the defendant during the term of the patent. (28)

   The effect of these rules is generally salutary: the lost profits doctrine aims to put patentees in the position they would have been in but for the infringement, and the tools the law uses to accomplish this end are quite economically sophisticated. But the high standard of proof means that there are many patentees who are not in fact made whole for the acts of infringement under the lost profits rule.

2. ARE REASONABLE ROYALTIES REASONABLE?

   Patentees who cannot prove lost profits, either because they didn't have any lost profits or because they failed to meet the standards of proof, are relegated to a "reasonable royalty" remedy. Reasonable royalties are like lost profits in that both are designed to compensate patentees for their losses. But there the similarity ends. Reasonable royalty law is designed with the nonmanufacturing patentee in mind. (29) And what it takes to "make the patentee whole" is very different if the patentee's only interest is in licensing the patent than if the patentee's interest is in excluding competition and maintaining a monopoly price. (30) Thus, reasonable royalty case law properly inquires into what the marketplace would actually pay for rights to the technology, bearing in mind that the licensee has to make a profit as well. (31) By contrast, it is not only possible but common that lost profits will exceed the defendant's gains from infringement. (32)

   The idea that patent damages tend to be greater in lost profits cases than in reasonable royalty cases makes sense for policy purposes, so long as the reasonable royalty awards go to patentees who are not in fact selling products in the market. But if the recipients of reasonable royalty damages are in fact competitors who failed to meet the rigorous requirements of proof of lost profits, the result may be that those patentees are undercompensated by a traditional reasonable royalty approach. Courts have responded to the perceived unfairness of this result (33) by expanding reasonable royalty damages in a...